Higher education is a major expense for many taxpayers. The average student loan debt among recent college graduates is about $30,000, according to data.
Whether you’re in school or on the job force, student loans can help or hurt you at tax time. Private and federal student loan borrowers stand to benefit from tax breaks, but student loan debt can also lead to tax burdens with forgiven or settled debt. Here’s what to know.
Tax credits and deductions for students
Tax credits and deductions that apply to educational expenses can lower your tax bill or increase your refund.
Tax Credits
If you paid for education costs (with or without student loans), the IRS allows you to claim the American Opportunity Tax Credit and the Lifetime Learning Credit. Both are tax credits, which reduce the amount of your income subject to tax.
You can claim up to $2,500 each year for up to four years with the American Opportunity Tax Credit. If this credit reduces your income tax to less than zero, you can get a refund. Under the Lifetime Learning Credit, you can claim up to $2,000 per return. This may reduce your tax bill but will not generate a refund.
Student loan interest deduction
If you pay interest on either private or federal student loans, the student loan interest deduction will allow you to reduce your taxable income by up to $2,500 annually.
“Congress understands that the cost of college is an incredibly high expense,” says Christine Ingram, CPA and owner of the accounting education website, Accounting in Focus. “It’s something they’ve provided to help people with that expense.”
When you reduce the amount of your income subject to tax, you don’t have to pay tax on that income. And that can push you into a lower tax bracket, which can translate into even more tax savings, Ingram says.
To claim the deduction, you must have used the loan to pay qualified education expenses for yourself, your spouse or a dependent. Your loan servicer should send you a Form 1098-E that shows how much interest you paid during the tax year. If you used a credit card to pay qualified expenses and interest on a loan, the IRS says you can claim that interest, too.
There are two downsides to the student loan interest deduction, Ingram says. You can only claim the $2,500 deduction once per return, whether you’re filing single or filing jointly. This means that if you are paying off student loans for yourself and your spouse, you will only claim it once.
What’s more, the deduction starts to decrease as you earn more income. Once your modified adjusted gross income is $85,000 or more filing single, or $175,000 or more filing jointly, you are not eligible for any credit. “The people who tend to take on a lot of debt are the people who are about to hit those thresholds,” says Ingram. “So they still have those payments, but they don’t get the benefit of that deduction.”
If your parents helped pay for your school costs, you need to consider who can claim the tax credit along with the student loan interest deduction. It can be you or your parents, but not both. The answer comes down to:
- Dependent position: To qualify for these tax breaks, you cannot be listed as a dependent on someone else’s tax return.
- Filing status: If you’re married, filing separately means you can’t claim any of these three education tax breaks.
- Income: Tax breaks usually have an income limit, so you’ll need to compare your income to your parents’. If one of you meets the income requirements, you can claim the tax exemption as long as you fit any other qualifications.
Your tax-filing status can affect your student loan payments
Federal student loan borrowers have more flexibility in repayment, with four income-driven repayment plans that limit monthly payments to a percentage of the borrower’s income reported to the IRS. After the borrower makes payments on time for 20 to 25 years, the government will waive any outstanding balance.
If you have federal student loans and file a joint return with a spouse, the Department of Education bases your payments on both incomes. If your combined income increases substantially after your marriage, your payments may increase substantially or the income may disqualify you from certain repayment programs. If your spouse is also paying federal student loans, the Department of Education helps a little here by prorating your loan payments. But if you and your spouse decide to file separately, the monthly payment will be based on your income.
There is one exception: Revised payments don’t take into account how you plan to earn, whether you file jointly or separately. It bases your payment on the combined income of you and your spouse.
Mark Gianno, CPA and president of the financial services company Gianno & Freda, has a client who is married but filing separately to receive a lower federal student loan payment. “In the process, he’s sacrificing a lot to get forgiveness,” says Ziano. For example, separate filers generally pay a higher tax rate, cannot claim certain credits and deductions (such as the student loan interest deduction), and may receive a reduced child tax credit. And once the loan is forgiven, Gianno says, there’s a tax hit: The forgiven amount will generally be considered taxable income.
If the two people have “radically different incomes” and the person with the lower income has larger student loans, it might be worth it, Ingram says.
Student loans that are settled or forgiven can lead to bigger tax bills
There are two main ways to pay less than originally agreed on your student loans: loan settlement and loan forgiveness.
If you are in default on a student loan, meaning you have missed several payments, you may be able to negotiate a debt settlement. This means the lender will accept a smaller lump sum as payment in full. But while it’s possible, it’s not guaranteed, and your credit rating will take a big hit as you miss payments.
Loan forgiveness is a program for federal student loan borrowers. After you’ve made payments for 20 to 25 years, the government will forgive any outstanding balance on the loan.
But here’s one of the major downsides of settled and forgiven debt: The IRS will count any discharged debt as taxable income. So if you’re in the 22% tax bracket and your $40,000 loan is forgiven, you’ll pay $8,800 in additional taxes.
You may qualify for an exemption, such as bankruptcy, that allows you to exclude the discharged debt from your gross income. You are considered bankrupt if the fair market value of your total assets is less than your total debts. “If you’re still fresh out of school and living in an apartment and trying to make ends meet,” says Giano, “if you really don’t have anything, you can show bankruptcy.”
Here’s some good news: If you have federal student loans and you qualify for the federal Public Service Loan Forgiveness Program, the government will forgive your remaining loan balance after you make 120 qualifying payments. Under this program, you don’t pay tax on the balance. The program was created to “increase the talent pool for potential employees in the public service,” Gianno says.
Student loans are not considered taxable income – but what else is?
The IRS defines income as any money you receive: wages, salaries, commissions, fees, tips, and more. Taxable income is any income left over after you subtract allowable deductions and adjustments.
When you tap into methods of paying for school, you need to consider whether the IRS will see the funds as taxable income. Here are two examples of what is generally and is not taxable:
Student Loans, Scholarships, and Grants: Generally not taxed. Student loans, whether private or federal, are generally not considered taxable income because they will be repaid at some point. Of course, if the loan is later discharged, you may have to pay income tax on the balance. Educational scholarships and grants are generally not considered taxable income, but certain rules apply. You must be a degree-seeking student at an eligible institution, use the funds only for eligible expenses, and meet certain other requirements.
Employer-provided benefits: Generally taxed. If your employer foots your tuition bill for your higher education or offers you a benefit to help pay off student loans through an educational assistance program, these funds may be taxable. You don’t have to pay taxes on the first $5,250 of an educational assistance program, but you generally have to pay taxes on benefits above that amount. On the other hand, 100% of student loan repayment assistance is viewed as taxable income.
Consider a plan before taking out a loan
If you’re still in school and haven’t taken on a lot of student loans, Ingram suggests taking a look at what your budget might look like after graduation.
“People spend a lot of time focusing on student loans after they’ve already got one,” she says. “They try to figure out how to pay them and what tax deductions to take.” She says the smart move is to spend more time thinking about these details before taking out a loan.